Sub-Prime Write-Downs more than 50% done: Are Write-Ups Coming Next?

S&P was out with a report today saying that the banks are more than half-way through in recognizing losses attributed to sub-prime mortgages. They revised their estimate of total losses up to $285B from $265B but this is much less than the estimates put out by investment banks: $325B from JPMorgan Chase, $400B from Morgan Stanley and Goldman Sachs, and even $600B from UBS.

This week different government agencies have started taking serious action to introduce liquidity into the MBS secondary market. The Fed’s decision to allocate $200B to exchange AAA rated MBS held by investments with Treasuries helped stabilize the market. Later today, news came out that Congress was considering more efforts to stabilize the mortgage market.

A proposal which will allow the FHA to offer $300B more in guarantees to help refinance distressed mortgage got some attention. Treasury Secretary Paulson introduced proposals to introduce rules to regulate over the counter markets which are currently unregulated, to restore confidence in counterparties and prevent future bubbles.

The message being sent is that the Fed, the Congress and the Treasury are now serious about intervening in the MBS market to ensure stability. The equity market rallied and Treasuries sold off after digesting the news of Carlyle Capital Mortgage Fund’s liquidation. This indicates that the markets are now internalizing the beginning of the end of the credit-crunch. The equity markets were frozen because of the credit-crunch; the attention shift away from credit problems bodes well. Investors can now start looking at the fundamentals of equities instead of being stuck in a technical trader driven market.

Since many of these securities do not trade actively, the banks used the ABX Home Equity Indices or some trades executed in an illiquid market to get the mark. However, many of the banks continue to hold the securities.
Fed Chairman Bernanke has suggested that banks should allow home-owners who are upside down, to refinance at lower principal levels. This gives the home-owners an incentive to stay in their home.

This will allow the bank to recognize the principal loss, get the bad loan off their books and provide stability to the housing market by reducing the amount of foreclosed inventory.
This also means that severity rates which measure the principal loss realized during a foreclosure may be lower than what the market has been using. Further, the expense associated with foreclosure: court fees, legal fees, auction fees, house taxes, home maintenance costs will be eliminated. For example if a bank agrees to refinance the loan at 80% of the original principal value, the original loan will be paid back with a 20% loss of principal. The severity rate in this case will be 20%.
To get an idea of how the banks have been marking down their assets, it would help to review the transcript of the Morgan Stanley’s Q4-2007 conference call (pages 7 and 8):

Prashant Bhatia – Citigroup
Hi, can you just help us reconcile the accounting impact of the $9 billion versus what the cash impact has been, so just realized versus unrealized?
John Mack
I’m sorry Prashant, in respect to what

?
Prashant Bhatia – Citigroup
Right. Okay. So when we think about — I think the $1.8 billion in exposure that’s left, is it fair to say that from where you are sitting, you’d probably just want to leave that exposure on until you have the cash flows end up performing on some of these positions? Or would you, if given the opportunity, liquidate that $1.8 billion?
John Mack
Well, I think that’s trading column. We’re on doing with the $1.8 billion is shown you a net exposure that comes out of our valuation using consistent valuation methodology. And just to get it out, the $1.8 billion exposure, remember what I said on November 7th, that is a function of assuming a 100% default with zero recovery and all your short expiring worthless.

?
John Mack
I think that she gave a ratio, but I am prepared to say that roughly 50% of the vintages are ’05 and that’s what quarters in November.
Roger Freeman – Lehman Brothers
But I guess the question would be if it’s only about 50%, the mark seems kind of stiff, if the remainder is later vintages where those ABS indices actually ended November roughly flat with the October. Can you give us little more color on?
John Mack
Sure.

Of course I can. Well, first of all, we are absolutely confident that the valuation we gave as of 31 October was a right using consistent valuation methodology. Two things happened in November, which changed the valuation which we have to look to is identifiable inputs.

One was the sell off as you know in the ’05 collateral which we can described. But two is in risking this position, we actually did execute observable trades, which we have to calibrate to, and it was that calibration to external marks that has driven the valuations

.
A few observations:
• Morgan Stanley continues to hold the securities. The losses were based on trades done in an illiquid market in November 2007.
• Much of the portfolio consists of CDOs based on mortgages issues in 2005 and early 2006. Many of the loans in these pools were 2/28 ARMs. The 2005 would already have reset, and hopefully refinanced. Many of the 2006 vintage will be reset this year and hopefully be refinanced as the interest rates come down and liquidity in the MBS market increases.
• The portfolio was valued using 100% default rate and 0% recovery (100% severity) to come up with the $9B write-down.

We will get a better idea of the real loss rates realized in the sub-prime portfolio next 18 months. Given all the action in Washington, it is very likely that the losses realized will be significantly less than what a 100% default rate with 100% severity would imply.